Economics book slide Case and Fair a good path to learn basics of economics

1. CHAShort-RunCostsa
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 32
PowerPoint Lectures for
Principles of Economics,
9e
By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
; ;

2. CHAShort-RunCostsa
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3. © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
8
PART II THE MARKET SYSTEM
Choices Made by Households and Firms
Short-Run Costs and
Output Decisions
Fernando & Yvonn Quijano
Prepared by:

4. CHAShort-RunCostsa
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8Short-Run Costs and
Output Decisions
Costs in the Short Run
Fixed Costs
Variable Costs
Total Costs
Short-Run Costs: A Review
Output Decisions: Revenues,
Costs, and Profit Maximization
Total Revenue (TR) and Marginal
Revenue (MR)
Comparing Costs and Revenues to
Maximize Profit
The Short-Run Supply Curve
Looking Ahead
CHAPTER OUTLINE
PART II THE MARKET SYSTEM
Choices Made by Households and Firms

5. CHAShort-RunCostsa
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Short-Run Costs and Output Decisions
You have seen that firms in perfectly competitive
industries make three specific decisions.
 FIGURE 8.1 Decisions Facing Firms

6. CHAShort-RunCostsa
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Costs in the Short Run
fixed cost Any cost that does not depend on the
firms level of output. These costs are incurred even
if the firm is producing nothing. There are no fixed
costs in the long run.
variable cost A cost that depends on the level of
production chosen.
total cost (TC) Fixed costs plus variable costs.
TC = TFC + TVC

7. CHAShort-RunCostsa
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Costs in the Short Run
total fixed costs (TFC) or overhead The total of
all costs that do not change with output even if
output is zero.
Total Fixed Cost (TFC)
Fixed Costs
TABLE 8.1 Short-Run Fixed Cost (Total and
Average) of a Hypothetical Firm
(1) Q (2) TFC (3) AFC (TFC/Q)
0
1
2
3
4
5
$1,000
1,000
1,000
1,000
1,000
1,000
$ −
1,000
500
333
250
200

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Costs in the Short Run
Total Fixed Cost (TFC)
Fixed Costs
 FIGURE 8.2 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm
Average fixed cost is simply total fixed cost divided by the quantity of output. As output
increases, average fixed cost declines because we are dividing a fixed number ($1,000) by
a larger and larger quantity.

9. CHAShort-RunCostsa
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Costs in the Short Run
Average Fixed Cost (AFC)
Fixed Costs
average fixed cost (AFC) Total fixed cost divided
by the number of units of output; a per-unit
measure of fixed costs.
TFC
AFC
q
=
spreading overhead The process of dividing total
fixed costs by more units of output. Average fixed
cost declines as quantity rises.

10. CHAShort-RunCostsa
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Costs in the Short Run
Total Variable Cost (TVC)
Variable Costs
total variable cost (TVC) The total of all costs
that vary with output in the short run.
total variable cost curve A graph that shows the
relationship between total variable cost and the
level of a firm’s output.

11. CHAShort-RunCostsa
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(9 x $2) + (6 x $1) = $24
(6 x $2) + (14 x $1) = $26
6
14
9
6
A
B
3 units of
output
(7 x $2) + (6 x $1) = $20
(4 x $2) + (10 x $1) = $18
6
10
7
4
A
B
2 units of
output
4
6
(4 x $2) + (4 x $1) = $12
(2 x $2) + (6 x $1) = $10
4
2
A
B
1 unit of
output
Total Variable Cost Assuming
PK = $2, PL = $1
TVC = (K x PK) + (L x PL)
Using
Technique
Units of Input Required
(Production Function)
K LProduce
TABLE 8.2 Derivation of Total Variable Cost Schedule from Technology and Factor
Prices
Costs in the Short Run
Total Variable Cost (TVC)
Variable Costs

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Costs in the Short Run
Total Variable Cost (TVC)
Variable Costs
 FIGURE 8.3 Total Variable
Cost Curve
In Table 8.2, total variable cost is
derived from production requirements
and input prices. A total variable cost
curve expresses the relationship
between TVC and total output.

13. CHAShort-RunCostsa
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Costs in the Short Run
Marginal Cost (MC)
Variable Costs
marginal cost (MC) The increase in total cost that
results from producing 1+ more unit of output.
Marginal costs reflect changes in variable costs.
TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost
Units of Output Total Variable Costs ($) Marginal Costs ($)
0
1
2
3
0
10
18
24
10
8
6

14. CHAShort-RunCostsa
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Costs in the Short Run
The Shape of the Marginal Cost Curve in the Short Run
Variable Costs
 FIGURE 8.4 Declining Marginal Product Implies
That Marginal Cost Will Eventually Rise with Output
In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies
diminishing returns (declining marginal product) and a limited capacity to produce.
As that limit is approached, marginal costs rise.

15. CHAShort-RunCostsa
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Costs in the Short Run
The Shape of the Marginal Cost Curve in the Short Run
Variable Costs
In the short run, every firm is constrained by some
fixed input that (1) leads to diminishing returns to
variable inputs and (2) limits its capacity to
produce. As a firm approaches that capacity, it
becomes increasingly costly to produce
successively higher levels of output. Marginal
costs ultimately increase with output in the short
run.

16. CHAShort-RunCostsa
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Costs in the Short Run
Graphing Total Variable Costs
and Marginal Costs
Variable Costs
 FIGURE 8.5 Total Variable Cost and
Marginal Cost for a Typical Firm
Total variable costs always increase
with output. Marginal cost is the cost
of producing each additional unit.
Thus, the marginal cost curve shows
how total variable cost changes with
single- unit increases in total output.
MCTVC
TVC
q
TVC
TVC =∆=
∆
=
∆
=
1Δ
ofslope

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Costs in the Short Run
Average Variable Cost (AVC)
Variable Costs
TVC
AVC
q
=
average variable cost (AVC) Total variable cost
divided by the number of units of output.

18. CHAShort-RunCostsa
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Costs in the Short Run
Average Variable Cost (AVC)
Variable Costs
TABLE 8.4 Short-Run Costs of a Hypothetical Firm
(1)
q
(2)
TVC
(3)
MC
(∆ TVC)
(4)
AVC
(TVC/q)
(5)
TFC
(6)
TC
(TVC + TFC)
(7)
AFC
(TFC/q)
(8)
ATC (TC/q or
AFC + AVC)
0 $ 0 $ − $ − $ 1,00
0
$ 1,000 $ − $ −
1 10 10 10 1,00
0
1,010 1,000 1,010
2 18 8 9 1,00
0
1,018 500 509
3 24 6 8 1,00
0
1,024 333 341
4 32 8 8 1,00
0
1,032 250 258
5 42 10 8.4 1,00
0
1,042 200 208.4
− − − − − − − −
− − − − − − − −

19. CHAShort-RunCostsa
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Costs in the Short Run
Graphing Average Variable Costs and Marginal Costs
Variable Costs
 FIGURE 8.6 More Short-Run
Costs
When marginal cost is below
average cost, average cost is
declining.
When marginal cost is above
average cost, average cost is
increasing.
Rising marginal cost intersects
average variable cost at the
minimum point of AVC.

20. CHAShort-RunCostsa
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Costs in the Short Run
Total Costs
 FIGURE 8.7 Total Cost = Total Fixed Cost + Total Variable Cost
Adding TFC to TVC means adding the same amount of total fixed cost to every level
of total variable cost. Thus, the total cost curve has the same shape as the total
variable cost curve; it is simply higher by an amount equal to TFC.

21. CHAShort-RunCostsa
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Costs in the Short Run
Total Costs
Average Total Cost (ATC)
average total cost (ATC) Total cost divided by
the number of units of output.
q
TC
ATC =
AVCAFCATC +=

22. CHAShort-RunCostsa
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Costs in the Short Run
Total Costs
Average Total Cost (ATC)
 FIGURE 8.8 Average Total Cost =
Average Variable Cost + Average
Fixed Cost
To get average total cost, we add
average fixed and average variable
costs at all levels of output.
Because average fixed cost falls
with output, an ever-declining
amount is added to AVC.
Thus, AVC and ATC get closer
together as output increases, but
the two lines never meet.

23. CHAShort-RunCostsa
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Costs in the Short Run
Total Costs
The Relationship Between Average Total Cost and Marginal Cost
If marginal cost is below average total cost,
average total cost will decline toward marginal
cost. If marginal cost is above average total cost,
average total cost will increase. As a result,
marginal cost intersects average total cost at
ATC’s minimum point, for the same reason that it
intersects the average variable cost curve at its
minimum point.
The relationship between average total cost and
marginal cost is exactly the same as the
relationship between average variable cost and
marginal cost.

24. CHAShort-RunCostsa
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Costs in the Short Run
Short-Run Costs: A Review
TABLE 8.5 A Summary of Cost Concepts
Term Definition Equation
Accounting costs Out-of-pocket costs or costs as an accountant would
define them. Sometimes referred to as explicit
costs.
−
Economic costs Costs that include the full opportunity costs of all
inputs. These include what are often called implicit
costs.
−
Total fixed costs Costs that do not depend on the quantity of output
produced. These must be paid even if output is zero.
TFC
Total variable costs Costs that vary with the level of output. TVC
Total cost The total economic cost of all the inputs
used by a firm in production.
TC = TFC + TVC
Average fixed costs Fixed costs per unit of output. AFC = TFC/q
Average variable costs Variable costs per unit of output. AVC = TVC/q
Average total costs Total costs per unit of output. ATC = TC/q ATC = AFC + AVC
Marginal costs The increase in total cost that results from
producing 1 additional unit of output.
MC = ∆TC/∆q

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Costs in the Short Run
Short-Run Costs: A Review
Average and Marginal Costs at a College
Costs in Dollars
Students Total Fixed Cost Total Variable
Cost
Total Cost Average Total Cost
500 $60 million $ 20 million $ 80
million
$160,000
1,000 60 million 40 million 100 million 100,000
1,500 60 million 60 million 120 million 80.000
2,000 60 million 80 million 140 million 70,000
2,500 60 million 100 million 60 million 60,000

26. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
perfect competition An industry structure in
which there are many firms, each small relative to
the industry, producing virtually identical products
and in which no firm is large enough to have any
control over prices. In perfectly competitive
industries, new competitors can freely enter and
exit the market.
homogeneous products Undifferentiated
products; products that are identical to, or
indistinguishable from, one another.
Perfect Competition

27. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
Perfect Competition
 FIGURE 8.9 Demand Facing a Single
Firm In a Perfectly Competitive Market
If a representative firm in a perfectly competitive market raises the price of its output
above $2.45, the quantity demanded of that firm’s output will drop to zero. Each firm
faces a perfectly elastic demand curve, d.

28. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
Total Revenue (TR) and Marginal Revenue (MR)
P x qTR =
= quantityxpricerevenuetotal
total revenue (TR) The total amount that a firm
takes in from the sale of its product: the price per
unit times the quantity of output the firm decides to
produce (P x q).
marginal revenue (MR) The additional revenue
that a firm takes in when it increases output by one
additional unit. In perfect competition, P = MR.

29. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
Comparing Costs and Revenues to Maximize Profit
 FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm
If price is above marginal cost, as it is at 100 and 250 units of output, profits can be increased by
raising output; each additional unit increases revenues by more than it costs to produce the
additional output. Beyond q* = 300, however, added output will reduce profits. At 340 units of output,
an additional unit of output costs more to produce than it will bring in revenue when sold on the
market. Profit-maximizing output is thus q*, the point at which P* = MC.
The Profit-Maximizing Level of Output

30. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
Comparing Costs and Revenues to Maximize Profit
The Profit-Maximizing Level of Output
As long as marginal revenue is greater than
marginal cost, even though the difference between
the two is getting smaller, added output means
added profit. Whenever marginal revenue
exceeds marginal cost, the revenue gained by
increasing output by 1 unit per period exceeds the
cost incurred by doing so.
The profit-maximizing perfectly competitive firm will
produce up to the point where the price of its
output is just equal to short-run marginal cost—the
level of output at which P* = MC.
The profit-maximizing output level for all firms is
the output level where MR = MC.

31. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
Comparing Costs and Revenues to Maximize Profit
A Numerical Example
TABLE 8.6 Profit Analysis for a Simple Firm
(1)
q
(2)
TFC
(3)
TVC
(4)
MC
(5)
P = MR
(6)
TR
(P x q)
(7)
TC
(TFC + TVC)
(8)
PROFIT
(TR − TC)
0 $ 10 $ 0 $ − $ 15 $ 0 $ 10 $ -10
1 10 10 10 15 15 20 -5
2 10 15 5 15 30 25 5
3 10 20 5 15 45 30 15
4 10 30 10 15 60 40 20
5 10 50 20 15 75 60 15
6 10 80 30 15 90 90 0

32. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
Comparing Costs and Revenues to Maximize Profit
A Numerical Example
Case Study in Marginal
Analysis: An Ice Cream
Parlor
An analysis of fixed costs,
variable costs, revenues, profits,
and opening longer hours were
used by this ice cream parlor to
determine whether to stay in
business.

33. CHAShort-RunCostsa
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Output Decisions: Revenues, Costs, and Profit Maximization
The Short-Run Supply Curve
 FIGURE 8.11 Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm
At any market price,a
the marginal cost curve shows the output level that maximizes profit. Thus, the
marginal cost curve of a perfectly competitive profit-maximizing firm is the firm’s short-run supply
curve.
a
This is true except when price is so low that it pays a firm to shut down—a point that will be discussed in
Chapter 9.

34. CHAShort-RunCostsa
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average fixed cost (AFC)
average total cost (ATC)
average variable cost (AVC)
fixed cost
homogeneous product
marginal cost (MC)
marginal revenue (MR)
perfect competition
spreading overhead
total cost (TC)
total fixed costs (TFC) or
overhead
total revenue (TR)
total variable cost (TVC)
total variable cost curve
variable cost
1. TC = TFC + TVC
2. AFC = TFC/q
3. Slope of TVC = MC
4. AVC = TVC/q
5. ATC = TC/q = AFC + AVC
6. TR = P x q
7. Profit-maximizing level of output for
all firms: MR = MC
8. Profit-maximizing level of output for
perfectly competitive firms: P = MC
REVIEW TERMS AND CONCEPTS